Advisory

Category: Capital
Subject:

Settlement Risk in Foreign Exchange Transactions

Date:

June 2013

Introduction
This Advisory establishes OSFIs expectations regarding the management of foreign exchange
settlement risk by banks, bank holding companies and trust and loan companies (collectively
referred to as banks in this advisory). The basis for this Advisory comes from the Basel
Committee on Banking Supervisions (BCBS) paper entitled Supervisory guidance for managing
risks associated with the settlement of foreign exchange transactions.
Banks are expected to take account of the nature, size, complexity and risk profile of their
foreign exchange transactions when assessing their practices against the principles in this
Advisory in the course of normal compliance reviews.
Further, banks are expected to develop a plan to remedy any deficiencies that come to light
during their assessments. This will enable them to respond to questions that may arise when
OSFI supervisors review their foreign exchange settlement risk management practices.

255 Albert Street

Ottawa, Canada
K1A 0H2
www.osfi-bsif.gc.ca

Table of Contents
Principle 1: Governance .............................................................................................................. 3
Principle 2: Principal risk............................................................................................................ 6
Principle 3: Replacement cost risk ............................................................................................ 10
Principle 4: Liquidity risk ......................................................................................................... 12
Principle 5: Operational risk ..................................................................................................... 14
Principle 6: Legal risk ............................................................................................................... 17
Principle 7: Capital for FX transactions.................................................................................... 18
Annex ........................................................................................................................................ 20
Glossary .................................................................................................................................... 25

Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 2

Principle 1: Governance
A bank should have strong governance arrangements over its foreign exchange (FX) settlementrelated risks, including a comprehensive risk management process and active engagement by the
board of directors (Board).1
OSFIs Expectations
Key considerations
1. A bank should have strong governance arrangements that ensure all FX settlementrelated risks are properly identified, measured, monitored and controlled on a firm-wide
basis.
2. A bank should have a comprehensive risk management framework to manage FX
settlement-related risks commensurate with the size, nature, complexity and risk profile
of its FX activities. This framework should cover all material risks including principal
risk, replacement cost risk, liquidity risk, operational risk and legal risk. The framework
should include policies and procedures, limit structures, management information
systems and key risk indicators, fails management, escalation procedures and an internal
audit and compliance program.
3. The risk management framework should also ensure that all risks associated with the
selection of specific pre-settlement and settlement arrangements used by a bank are
properly identified, measured, monitored and controlled.
Strong governance of FX settlement-related risks
1.1
The Board is ultimately responsible for approving and overseeing the banks strategic
objectives, risk appetite framework and corporate governance structure. The Board oversees
senior management and ensures that managements actions to monitor and control FX
settlement-related risks are consistent with the risk appetite and strategy approved by the Board.
These efforts should be supported by appropriate reporting to ensure that the Board receives
sufficient and timely information regarding how the bank is managing its FX settlement-related
risks. The banks overarching governance framework should include a comprehensive program
of internal controls to measure these risks.
Comprehensive risk management framework
1.2
A bank should have a comprehensive risk management framework for all material risks
inherent to the life cycle of an FX transaction, including principal risk, replacement cost risk,
liquidity risk, operational risk and legal risk. The framework should reflect the size, nature,
complexity and risk profile of the banks FX activities; provide mechanisms that properly
identify, measure, monitor and control associated risks; and be integrated into the overall risk
management process.

With regard to governance structures, see OSFIs Corporate Governance Guideline..

Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 3

Policies and procedures

1.3
The Board should oversee how effectively management implements the banks risk
policies, including policies for managing all of the risks associated with FX settlement. Policies
and procedures should be comprehensive, consistent with relevant laws, regulations and
supervisory guidance and provide an effective system of internal controls. Policies and
procedures should be clearly documented. Once established, policies should be periodically
reviewed for adequacy based on changes to financial markets and internal business strategies.
Limit structure
1.4
A bank should set formal, meaningful counterparty exposure limits for FX trading and
settlement that include limits for principal risk and replacement cost risk. In particular, the size
and duration of principal exposures that arise from non-PVP settlements should be recognised
and treated equivalently to other counterparty exposures of similar size and duration. Limits
consistent with the banks risk appetite should be established by the credit risk management
department, or equivalent, on a counterparty basis. Usage should be controlled throughout the
day to prevent trades that would create principal and replacement cost exposures that exceed
these limits. Exceptions to established limits should be approved in advance (prior to trading) by
the appropriate authority in accordance with established policies and procedures.
Management information systems and key risk indicators
1.5
A bank should have sufficiently robust systems to capture, measure and report on FX
settlement-related exposures on a bank-wide basis, across business lines and counterparties. The
sophistication of systems should reflect the risk profile and complexity of the bank. Timely
reports should be provided to the banks Board and senior management and include appropriate
key risk indicators and risk issues that could result in a potential loss.
Fails management
1.6
A bank should ensure that its framework identifies FX fails and captures the full amount
of the resulting FX settlement-related risks as soon as practicable, to allow senior management to
make appropriate judgements regarding the nature and severity of the exposure.
Escalation procedures
1.7
A bank should clearly define, in its policies, the nature and types of incidents that would
constitute issues requiring escalation to, and approval by, senior management or the Board.
There should be clear and detailed escalation policies and procedures to inform senior
management and the Board, as appropriate, of potential FX issues and risks in a timely manner,
and seek their approval when required. This should include, but not be limited to, exceptions to
established limits and fails management.
Internal audit and compliance program
1.8
A bank should have an independent and effective internal audit function that can evaluate
the effectiveness of managements efforts to control or mitigate the risks associated with settling
FX transactions. Internal audit should have an independent reporting line to the banks Board or
audit committee of the Board, audit staff with the necessary expertise and experiences on the
subject, and sufficient status within the bank to ensure that senior management responds
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 4

appropriately to findings and recommendations. In addition, a bank should have an effective

compliance function that manages compliance-related matters associated with settling FX
transactions. The Board should oversee the management of the compliance function.
Selection of appropriate pre-settlement and settlement arrangements for FX transactions
1.9
A banks risk management framework should include procedures to identify the most
appropriate settlement method for each type of FX transaction, given the size, nature, complexity
and risk-profile of the banks FX activities. In making this evaluation, a bank should carefully
measure the size and duration of its principal exposures. This framework should assess all
available settlement methods and their efficacy at reducing or eliminating principal risk and
other FX settlement-related risks. These implications need to be identified, assessed and
incorporated into the banks decision-making process. Once an appropriate settlement method is
chosen, a bank should properly manage all FX settlement-related risks associated with that
method. Where PVP arrangements are available, but a bank or its client has chosen not to use
them, the bank should periodically reassess its decision. (See Annex: FX settlement-related risks
and how they arise, Section C, for descriptions of available settlement methods and their
respective risk implications).
Selection of a Financial Market Infrastructure (FMI)
1.10 When choosing to use or participate in an FMI, a bank should conduct robust initial due
diligence to assess the associated risks. The initial due diligence should include a review of legal,
operational, credit and liquidity risks associated with the use of an FMI and its participants and
controls. A bank should have a thorough understanding of an FMIs rules and procedures, as
well as any responsibilities and FX settlement-related risks that it may assume through its use or
participation, directly or indirectly. A bank must ensure that it has the appropriate policies,
procedures and internal control structure to adequately manage its risks and to fulfil its
responsibilities to the FMI and its clients. Once a bank chooses to use or participate in an FMI, it
should conduct periodic monitoring to identify significant changes to the FMIs processes or
controls that may affect its risk exposures. If significant changes occur, the bank should update
its risk analysis, as appropriate. To the extent that an FMI is subject to the Principles for
financial market infrastructures,2 the bank should refer to available disclosures based on the
principles when conducting its own due diligence and periodic monitoring of the FMI.
Selection of a correspondent bank
1.11 A banks risk management framework should include policies and procedures for
evaluating the risks and benefits of using one or more correspondent banks to settle its FX
transactions in each currency. The framework should consider the potential size, form and
maturity of the banks exposure to its correspondents; and include an evaluation of each
correspondents financial condition and the risk profile of each correspondents jurisdiction. It
should include an assessment of any credit, liquidity, operational and legal risks associated with
using correspondent banking services. The framework should provide for periodic reviews of the
banks correspondent banks and have procedures in place to mitigate any FX settlement-related
risks that may arise.
2

See Principles for financial market infrastructures, CPSS/IOSCO, April 2012.

Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 5

Dependence on other institutions

1.12 A bank should consider its level of dependence on other institutions for settling its FX
transactions. It should assess the potential impact of disruption and mitigate the FX settlementrelated risks, as appropriate. Such risk mitigants may include establishing dual or backup
correspondent or settlement banks to make payments, or joining an FMI directly. The
appropriate method should consider costs, testing arrangements, switching time, time to onBoard, legal agreements, service fees, etc.

Principle 2: Principal risk

A bank should use FMIs that provide payment-versus-payment (PVP) settlement to eliminate
principal risk when settling FX transactions. Where PVP settlement is not practicable, a bank
should properly identify, measure, control and reduce the size and duration of its remaining
principal risk.
OSFIs Expectations
Key considerations
1. A bank should eliminate principal risk by using FMIs that provide PVP settlement, where
practicable.
2. Where PVP settlement is not practicable, principal risk should be properly identified,
measured, monitored and controlled. In particular, measurement of exposure should not
underestimate size and duration and should be subject to binding ex-ante limits and other
controls equivalent to other credit exposures of similar size and duration to the same
counterparty.
3. A bank should reduce the size and duration of its principal risk as much as practicable.
Eliminating principal risk using PVP settlement
2.1
A bank should eliminate principal risk by using FMIs that provide PVP settlement, where
practicable. In addition to a number of regional settlement arrangements, there are also
mechanisms that provide global PVP settlement. PVP arrangements are designed to eliminate
principal risk, but will not eliminate a banks replacement cost risk or liquidity risk. A bank
should identify and manage these risks effectively.
2.2
While a bank should maximise its use of PVP, it may still have trades that cannot be
settled through a PVP arrangement (e.g. certain same day trades, trades in certain products or
currencies, trades with counterparties not eligible for PVP settlement, etc.). To further reduce
principal risk, the bank should support initiatives to have such trades become eligible for
settlement through available PVP arrangements.
2.3
A bank may access the services of a PVP arrangement as a direct participant or as an
indirect participant. A bank that is an indirect participant, or third party, should determine
whether the settlement processes of the direct participant, or third party service provider
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 6

(including any internalised or on-us settlement processes it may use), creates principal risk
exposure. Principal risk exposures may occur between the bank and the direct participant, or
between the bank and its counterparty (in internalised settlement).3 If principal risk exists, then
the bank should manage it accordingly.
Controlling remaining principal risk
Setting and using limits
2.4
Where PVP is not practicable, a bank should manage its remaining principal risk. This
will involve setting principal risk limits that are binding; measuring expected exposures
appropriately to prevent those limits from being broken when trades are executed; and
monitoring the subsequent status of the trades to take prompt action when problems arise.
Management of principal risk should be fully integrated into a banks overall risk management
process.
2.5
A bank should ensure that principal risk to a counterparty is subject to prudent limits.
Principal risk should be subject to an adequate credit control process, including credit evaluation
and a determination of maximum exposure to a particular counterparty. Counterparty exposures
arising from principal risk should be subject to the same procedures used to set limits on other
exposures of similar duration and size to that counterparty.
2.6
The trading limits applied by a bank should be binding, namely, usage should be
monitored and controlled throughout the day to prevent trades that would create exposures
during the settlement process that would exceed the limit.4 Where a bank is acting as a prime
broker, it should have ex-ante processes in place to prevent client trades from creating exposures
that would exceed the limit.5 When a decision is made to allow a client to exceed a limit,
appropriate approval should be obtained. A bank that exceeds its principal risk limit with a
particular counterparty should reduce its exposure as soon as is practicable.
2.7
To ensure that the limits are binding, a bank should use an ex-ante process that updates
and reports exposure on a timely basis, preferably as each trade is executed. If a bank has limited

Principal exposure related to internalised settlement occurs where execution or authorisation of the relevant entry
in the on-us account denominated in the currency being sold is not conditional upon execution or authorisation of
the corresponding entry in the on-us account in the currency being bought (See Progress in reducing foreign
exchange settlement risk, CPSS, May 2008 Box 2, Settlement methods).
Frequent requests for intra-day limit increases by the same client should prompt the bank to assess its approved
risk appetite for that client and the additional risk that is being assumed.
For example, prime brokers typically support high-frequency trading clients by extending credit sponsorship and
access to various electronic FX trading platforms. Given the short time frames associated with high-frequency
trading activities, risk positions by high-frequency traders can accumulate rapidly under the name of a prime
broker; thereby, raising the need for the prime broker to closely monitor and control its clients activities. For
more information about high-frequency trading and FX prime brokerage relationships, see High-frequency
trading in the foreign exchange market, The Markets Committee of the Bank for International Settlements,
September 2011.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 7

capability to update and report exposure on a timely basis, then the bank needs to have effective
post-trade risk management controls to minimise limit breaches.6
Measuring expected principal risk
2.8
For a bank to estimate the expected principal risk that will arise from a trade during its
settlement process and to determine whether the counterparty limit will be exceeded, it needs to
accurately measure when that exposure will begin and when that exposure will end. This requires
the bank to know the relevant unilateral cancellation deadline for the currency it sold and when
the incoming payment for the currency it bought will be received with finality and is reconciled.
A bank will also need to determine whether it is appropriate to use approximate, rather than
exact, measures of exposure that may arise during a trades settlement.
(a)

Unilateral payment cancellation deadlines

2.9
A banks principal risk exposure to its counterparty begins when a payment order on the
currency it sold can no longer be recalled or cancelled with certainty this is known as the
unilateral payment cancellation deadline.7 A bank should reduce the duration of its exposures
by having the capability to unilaterally cancel payment instructions as late as practicable. This
might require changes to systems and processes used to process internal payments. The exposure
ends when the bank receives the purchased currency with finality. The duration of principal risk
can vary depending on the currency pair being settled and the correspondent banking
arrangements used by the bank and its counterparty.
2.10 A key factor in determining a unilateral payment cancellation deadline is the latest time a
correspondent guarantees to satisfy a cancellation request (the guaranteed cut-off time). Service
level agreements should identify this cut-off time. In instances where an agreement may not
specify a guaranteed cut-off time or a bank may not have a written agreement, the bank and its
correspondent should establish a specific cut-off time as late as practicable.8,9
2.11 A bank should be able to identify and halt individual payments up to the cut-off times
(regardless of time zone issues) guaranteed by its correspondents or the payment system in which
it participates without disrupting the processing of other outgoing payments.10 Where a banks
internal operational factors limit the banks ability to do so, its effective unilateral payment
cancellation deadline may be earlier than the guaranteed correspondent cut-off time. In some
cases, the unilateral payment cancellation deadline may actually be earlier than the time the
payment order is normally sent to the correspondent. This could occur, for example, if cancelling
6

10

For example, if a settlement limit is breached for a particular value date, auto-pricing of trades is prevented from
executing further trades for that value date.
Since this deadline may be one or more business days before the settlement date, this risk can last for a
significant period of time.
Note that unilateral delay in sending payment instructions may increase the correspondents operational risk (e.g.
incorrect execution of payment instructions).
If a bank acts as its own paying agent (e.g. if the bank is a direct participant in the payment system for the sold
currency), then its unilateral cancellation deadline for that currency reflects its internal payment processing rules
and procedures and those of the relevant payment system.
In addition to impacting a universal cancellation deadline, disruption of outgoing payments may impair a banks
ability to make timely payments to its counterparties.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 8

an internally queued, but still unsent, payment order requires manual intervention. To ensure
effective processing consistent with unilateral payment cancellation deadlines under stress, a
bank should periodically test with its branches and payment correspondents.
(b)

Reconciling incoming payments

2.12 In order to appropriately calculate when the principal exposure of a specific trade will
end, a bank should incorporate its process for reconciling incoming payments and the point in
time that it will identify the final or failed receipt of the purchased currency. To avoid
underestimating exposures, the bank should assume that funds have not been received until credit
to its correspondent bank (nostro agent) account has been confirmed and the bank has
determined which trades have successfully settled and which have failed to settle.
2.13 A bank should minimise the period of uncertainty (i.e. the time between actual final
receipt and reconciliation) by arranging to receive timely information on final payment receipt
from its correspondent bank.
(c)

Use of approximation techniques

2.14 When calculating expected principal risk using approximation methods, a bank should
not underestimate the risk.11 This requires that the bank identify the relevant unilateral payment
cancellation deadlines and reconciliation process timelines for each currency pair.
(d)

Fails

2.15 Effective monitoring of failed transactions is crucial for measuring and managing
principal risk, as unexpected fails cause exposures to be higher than predicted. A bank should
have a framework that monitors fails and properly accounts for them in its exposure measures.
Reducing the size of remaining principal risk
2.16 Where PVP settlement is not used, a bank should reduce the size of its principal risk as
much as practicable. A bank could use obligation netting to reduce the size of its principal risk
exposures. Depending on trading patterns, legally binding obligation netting permits a bank to
offset trades to a counterparty so that only the net amount in each currency is paid or received.
To allow exposures to be measured on a net basis, netting arrangements should be legally sound
and enforceable in all relevant jurisdictions.
2.17 A bank should use legally enforceable bilateral netting agreements and master netting
agreements (e.g. ISDA)12 with all counterparties, where practicable. The netting agreements13
11

12

13

For example, as noted in Progress in reducing foreign exchange settlement risk (CPSS, 2008), the most
commonly cited estimation method used is the calendar day method, where banks measure their daily
settlement exposures as the total receipts coming due on settlement date. Such a method can lead to
underestimation of risk.
Master netting agreements are not valid in all jurisdictions. If a bank trades in a jurisdiction that does not support
master netting agreements, then it should manage FX settlement-related principal risk appropriately (usually
gross).
A bank should understand the implications of not having a netting agreement with a counterparty (e.g. where FX
1trading is restricted to very short tenors) and manage this risk accordingly.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 9

should contain legally enforceable provisions for close-out netting and obligation netting. (See
Annex: FX settlement-related risks and how they arise, Section C, for descriptions of netting
arrangements).
2.18 If a counterpartys chosen method of settlement prevents a bank from reducing its
principal risk (e.g. a market participant does not participate in PVP arrangements or does not
agree to use obligation netting), then the bank should consider decreasing its exposure limit to
the counterparty or creating incentives for the counterparty to modify its FX settlement methods.
Principle 3: Replacement cost risk
A bank should employ prudent risk mitigation regimes to properly identify, measure, monitor
and control replacement cost risk for FX transactions until settlement has been confirmed and
reconciled.
OSFIs Expectations
Key considerations
1. Replacement cost risk should be properly identified, measured, monitored and controlled.
In order to ensure that the size and duration of exposures are not underestimated, a bank
should identify and assess the impact of its assumptions regarding timing of FX
settlement.
2. A bank should use legally enforceable netting agreements to reduce its replacement cost
risk, where practicable.
3. A bank should use legally enforceable collateral arrangements and should have an
explicit policy on margin, eligible collateral and haircuts to reduce replacement cost risk,
where practicable. Where possible, a bank should exchange (i.e. both receive and
deliver) the full amount of variation margin necessary to fully collateralise the mark-tomarket exposure on physically settling FX swaps and forwards. Variation margin should
be exchanged frequently (for example daily) with a low minimum transfer amount.
Identifying, measuring, monitoring and controlling exposures
3.1
A bank should employ effective replacement cost risk management tools to identify,
measure, monitor and control collateralised and uncollateralised exposures.
Setting and using limits
3.2
Meaningful limits on exposures, including replacement cost risk, are an integral part of
an effective risk-management framework. Replacement cost risk limits should be established by
maturity buckets to control current exposure and potential future exposure14, 15. Banks should
14

15

The potential future exposure sets an upper bound on a confidence interval for future credit exposure related to
market prices over time.
The methodology used to calculate the FX exposure will depend on whether the bank uses an agreed-upon
internal model or the standardised approach. Limits should be assigned accordingly.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 10

consider other measures to further control the replacement cost risk, such as regularly measuring
stress test results against limits.
Duration of replacement cost risk and the timing of settlement
Reconciliation of settlement
3.3
Until the final settlement of FX transactions is confirmed and reconciled, a bank cannot
be certain that it is no longer exposed to replacement cost risk for those transactions. In order to
avoid underestimation of potential replacement cost risk, a bank should assume that the exposure
begins at trade execution and continues until final settlement of the transaction has been
confirmed and reconciled.
Close-out netting and gross settlement
3.4
A bank should identify and assess the impact of its assumptions regarding the timing and
nature of settlement when measuring replacement cost risk under a close-out netting agreement.
For example, a bank with close-out netting agreements might measure and manage replacement
cost risk on a bilateral net basis with the assumption that either all transactions with a single
counterparty due to settle on a particular day will settle or none will settle. Since payments to
settle FX transactions may be made at any time, from the opening of business in the Asia-Pacific
region to the close of business in the Americas, this assumption may be faulty. 16 Therefore, the
bank should manage its replacement cost risk according to actual settlement times to avoid
underestimating its risk.
Netting and collateral arrangements
Netting
3.5
A bank should use legally enforceable bilateral netting agreements and master netting
agreements with all counterparties, where practicable. The netting agreements should include
provisions for close-out netting and obligation netting. Close-out netting reduces risk and
provides legal clarity regarding a surviving banks claims and/or obligations with respect to a
defaulted counterparty. It mitigates the risk of being forced to make payments of gross principal,
or of gross marked-to-market losses, to the defaulted counterparty, while the defaulted
counterpartys obligations become unsecured liabilities in a bankruptcy process.
Collateral arrangements
3.6
A bank should use legally enforceable collateral arrangements (e.g. ISDA credit support
annexes) to mitigate its replacement cost risk. Collateral arrangements should describe the
parties agreement on all aspects of the margining regime, including collateral eligibility, timing
and frequency of margin calls and exchanges, thresholds, valuation of exposures and collateral
and liquidation.
3.7
Where possible, a bank should exchange (i.e. both receive and deliver) the full amount of
variation margin necessary to fully collateralise the mark-to-market exposure on physically
16

For instance, even if a bank is flat with a particular counterparty from a bilateral net replacement cost
perspective, it is possible that all of its out-of-the-money trades could settle, while all of its in-the-money
trade could fail.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 11

settling FX swaps and forwards. Variation margin should be exchanged frequently (e.g. daily)
with a low minimum transfer amount. Collateral management policies and procedures, which
should be reviewed on a periodic basis, should at a minimum address: a) collateral eligibility, b)
collateral substitution, and c) collateral valuation.
3.8
Non-cash collateral assets should be highly liquid in order to be liquidated in a reasonable
amount of time to cover mark-to-market losses. Valuations of collateral should be appropriately
calibrated to reflect underlying risks during both normal and stressed market conditions. More
stable and conservative/higher haircuts can be expected to moderate the procyclical impact of
these arrangements.
Principle 4: Liquidity risk
A bank should properly identify, measure, monitor and control its liquidity needs and risks in
each currency when settling FX transactions.
OSFIs Expectations
Key considerations
1. A bank should ensure that its liquidity needs and risks are appropriately represented in
the banks liquidity risk management framework.17
2. A bank should identify, measure, monitor and control its liquidity needs in each currency
and have sufficient liquidity resources to meet those needs in normal and stressed
conditions.
3. A banks liquidity risk management framework should incorporate the liquidity risks that
arise from its use of, and the various roles it may play in, an FMI, as well as from its use
of correspondent banks.
Liquidity risk management framework
4.1
A bank should appropriately manage its liquidity needs and risks to ensure that it is able
to meet its FX payment obligations on time. A banks failure to meet its FX payment obligations
in a timely manner may impair the ability of one, or more, counterparties to complete their own
settlement, which can lead to liquidity dislocations and disruptions in the payment and settlement
systems.
4.2
A bank should manage its overall liquidity needs and risks in accordance with existing
international supervisory guidance.18 A banks liquidity needs and risks should be appropriately
represented in a banks liquidity risk management framework. The framework should address
17

18

This principle focuses on funding liquidity risk. Funding liquidity risk is the risk that the firm will not be able to
efficiently meet expected and unexpected current and future cash flow and collateral needs without affecting
either daily operations or the financial condition of the firm. Market liquidity risk is the risk that a firm cannot
easily offset or eliminate a position at the market price due to inadequate market depth or disruption.
See Principles for sound liquidity risk management and supervision, BCBS, September 2008 and Basel III:
International framework for liquidity risk measurement, standards and monitoring, BCBS, December 2010.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 12

how the banks liquidity needs and risks in each currency will vary based on the chosen method
of settlement. In addition, the framework should incorporate stress tests using various severe, but
plausible, scenarios.
Identify and manage liquidity needs
4.3
A bank should identify, measure, monitor and control its liquidity needs in each currency,
taking into consideration the settlement method and applicable netting arrangements. A bank
should be able to prioritise time-specific and other critical payment obligations to meet payment
deadlines. This is particularly important for a bank that uses an FMI to settle its FX obligations.
While settlement through an FMI can reduce a banks overall liquidity needs, it can also place
high demands on a bank to make time-critical payments to settle its FX transactions. In order to
meet its payment obligations in a timely manner, a bank should maintain sufficient available
liquid resources and have the ability to mobilise those resources, as required. A bank should
identify and manage the timeframes required to mobilise different forms of collateral, including
collateral held on a cross-border basis.
Impact of FX settlement failure
4.4 A bank may face a significant liquidity shortfall if a counterparty fails to deliver a leg of an
FX transaction (the purchased currency) on time. This situation may be exacerbated in a nonPVP settlement process, whereby the bank has already paid away the sold currency and cannot
use those funds as collateral or to swap outright to obtain the needed counter-currency. A bank
should account for these risks in its liquidity risk management framework and develop
contingency plans to address possible liquidity shortfalls.
4.5
A bank may settle its FX payment obligations based on a bilateral or multilateral net
position in each currency (position netting) even though the underlying obligations remain gross
from a legal perspective. When this is the case, a bank should understand and address the risk
that its liquidity needs could change materially following a settlement disruption. In particular,
the failure of a counterparty or a settlement disruption in an FMI could lead to a scenario where a
banks net liquidity needs increase significantly by reverting to gross liquidity needs.
Liquidity risks associated with an FMI
4.6
A bank that settles its FX obligations through an FMI should assess the FMIs rules and
procedures to identify potential liquidity risks. For example, a bank should understand an FMIs
rules for rescinding trades and the associated liquidity impact on the bank. In addition, a bank
may use certain liquidity-saving mechanisms to reduce its funding needs and should assess and
manage its risk resulting from the absence of such mechanisms.19 Further, as noted above, a
participant failure or a disruption to the operations of an FMI may change a banks liquidity
requirements. For example, if a participant fails to make payment or settlement is disrupted, then
the remaining participants may be required to make unexpected funding payments to settle their
transactions. A bank should incorporate these risk scenarios into its liquidity stress tests and
make appropriate adjustments to its liquidity management policies, procedures and contingency
funding plans.
19

In/out swaps (see Glossary) are examples of liquidity-saving mechanisms.

Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 13

4.7
A bank may have additional responsibilities associated with being an FMI member that
should be considered in its liquidity risk management framework. For example, a bank may
provide third party settlement services, correspondent banking services or credit to its customers
to facilitate FMI settlement. Further, a bank may also be a liquidity provider to an FX settlement
FMI.20 If an FMI needs to draw on its liquidity facilities, a provider bank may experience
liquidity stresses resulting from the combination of its own FX obligations and the needs of the
FMI. As these situations are likely to occur during periods of significant market stress, a bank
should incorporate these risk scenarios in its liquidity stress tests. In these scenarios, a bank
should consider that normal funding arrangements may not be available.
Liquidity risks associated with the use of a correspondent bank
4.8
When choosing to settle FX activities through a correspondent bank (nostro agent), a
bank should ensure that the arrangement allows it to meet its FX obligations in each currency on
a timely basis under varying circumstances. For example, a bank should assess the impact of a
correspondent bank restricting the provision of intraday credit on its ability to meet its FX
obligations, particularly if cross-border collateral would need to be mobilised to facilitate
settlement. In addition, a bank should recognise the potential for operational or financial
disruptions at its correspondent bank to disrupt its own liquidity management. A bank should
assess such risks and consider appropriate mitigants, such as establishing alternative settlement
arrangements to ensure it can continue to meet its FX obligations on time.21
Principle 5: Operational risk
A bank should properly identify, assess, monitor and control its operational risks. A bank should
ensure that its systems support appropriate risk management controls, and have sufficient
capacity, scalability and resiliency to handle FX volumes under normal and stressed conditions.
OSFIs Expectations
Key considerations
1. A bank should ensure that its operational risks are appropriately represented in the banks
operational risk management framework.
2. A bank should maximise the use of straight-through processing (STP) and other effective
means to control operational risks.
3. A bank should confirm trades in a timely manner, using electronic methods and standard
settlement instructions,22 where practicable.
4. A bank should have a robust capacity management plan to ensure that its systems have
sufficient capacity and scalability to handle increasing and high-stress FX trading
volumes. The plan should include the timely monitoring of trading volumes and capacity
20
21
22

Many FMIs rely on liquidity from members to effect settlement.

See Principles for Sound Liquidity Risk Management and Supervision, BCBS, September 2008 Principle 8.
Standard settlement instructions may also be referred to as standing settlement instructions.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 14

utilisation of key systems to prevent it from approaching critical levels. A bank that
engages in high-frequency trading, or has prime brokerage clients that engage in such
activity, should monitor trading volumes in real-time and assess the potential for large FX
trading spikes.
5. A bank should have robust business resiliency and continuity plans to manage its
operational risks and complete its FX settlement obligations.
Operational risk management framework
5.1
A bank should manage its operational risks in accordance with current international
supervisory guidance.23 A bank should establish an operational risk management framework that
identifies, assesses, monitors and controls a banks operational risks. The framework should
address the accuracy, capacity and resiliency of a banks operational processes and systems for
FX settlement. A bank should periodically reassess its operational risks, including risks that stem
from changes in its FX portfolio (e.g. new products).
5.2
A banks operational risks can arise from deficiencies in information systems, internal
processes, personnel or disruptions from external events. These risks can lead to inadequacies in
the accuracy, capacity and resiliency of a banks operations and cause delays or errors in trading
data or confirmation of FX trades. Further, operational risks can lead to losses resulting from the
banks failure to meet obligations on time, and create or exacerbate other risks (e.g. principal
risk, replacement cost risk, liquidity risk and reputational risk).
Straight-through processing (STP)
5.3
A bank should maximise the use of STP by employing systems that automatically feed
transactions, adjustments and cancellations from trade execution systems to other internal
systems, such as operations and credit-monitoring systems. STP helps to ensure that data is
disseminated quickly, accurately and efficiently throughout the bank, and allows for effective
monitoring and control of risks from trade execution to settlement. For example, STP can
facilitate the timely confirmation of trades with counterparties and eliminate errors from manual
processing. Maximising the use of STP, however, does not fully eliminate operational risk. In
addition, STP systems require monitoring and sufficient capacity and scalability. In the event
that STP systems are disrupted, a bank should have contingency procedures to continue its
operations.
Trade confirmation and affirmation24
5.4
A bank should establish processes and procedures that allow it to confirm or positively
affirm FX trades as soon as practicable after execution to reduce the potential for losses from
market risk or other sources. Where practicable, a bank should use electronic methods and
standard settlement instructions to maximise the use of STP and allow for prompt confirmation
and affirmation. Escalation procedures should be in place to resolve unconfirmed transactions.
23
24

See Principles for the sound management of operational risk, BCBS, June 2011.
A trade confirmation is legal evidence of the terms of an FX transaction. A confirmation should include trade
details, settlement instructions and other relevant information to allow each counterparty to agree to the trade
terms. Trade affirmation involves acknowledging a counterparty trade notification or confirmation. Both trade
confirmation and affirmation can take many forms (e.g. electronic, paper or voice over a recorded phone line).
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 15

Trade confirmations and affirmations should be transmitted in a secure manner to mitigate the
possibility of theft or fraudulent correspondence. As the confirmation and affirmation processes
are critical controls, these functions should be handled independently of the trading division.
Capacity
5.5
A bank should have a robust capacity management plan for its FX systems, including
trading, credit monitoring, operations, prime brokerage and settlement systems. When assessing
capacity needs, a bank should consider the sufficiency of FX systems and operational personnel.
5.6
A bank should ensure its FX systems have sufficient capacity and scalability to handle
increasing and high-stress FX volumes. A banks capacity plan should include forecasting of
expected and high-stress capacity needs. The forecasts should consider the FX trading behaviour
of the bank and its clients. In addition, a bank should also work with relevant FMIs when
establishing capacity policies and high-stress capacity requirements.
5.7
A bank should ensure its FX systems are designed appropriately for the scale of its
current and expected FX business activity. For example, a bank that offers FX prime brokerage
services should ensure that the operational arrangements supporting its prime brokerage
activities integrate seamlessly with the banks FX systems and do not cause undue operational
risk. Further, a bank should design its FX systems to accommodate the potential for large trading
spikes in stress situations, as appropriate. Finally, a banks FX systems should be flexible enough
to meet changing operational needs.
5.8
The capacity plan should include timely monitoring of trading volumes and capacity
utilisation of key systems. Volume monitoring is critical to a bank that engages in highfrequency trading or has prime brokerage clients that engage in such activity, and should be
reflected in the robustness of their capacity management plan.25 A bank should monitor trading
volumes in a timely manner to prevent them from reaching a critical level and assess the
potential for large FX trading spikes.
Contingency planning
5.9
A bank should develop and test its business resiliency and continuity plans to ensure
continued operations following a disruption. A bank should identify and address various
plausible events that could lead to disruptions in their FX-related operations and should have
appropriate systems, backup procedures and staffing plans to mitigate such disruptions. Business
continuity plans should be documented and periodically reviewed, updated and tested.

25

For more details on high-frequency trading, see High-frequency trading in the foreign exchange market, The
Markets Committee of the Bank for International Settlements, September 2011.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 16

Principle 6: Legal risk 26

A bank should ensure that agreements and contracts are legally enforceable for each aspect of
its activities in all relevant jurisdictions.
OSFIs Expectations
Key considerations
1. A bank should ensure that netting and collateral agreements, including provisions for
close-out netting, are legally enforceable in all relevant jurisdictions.
2. A bank should identify when settlement finality occurs so that it understands when key
financial risks are irrevocably and unconditionally transferred as a matter of law.
Enforceability
6.1
Contracts, and actions taken under contracts, should be legally enforceable with a high
degree of certainty in all relevant jurisdictions even when a counterparty defaults or becomes
insolvent.27 A bank should understand whether there is a high degree of certainty that contracts,
and actions taken under such contracts, will not be subject to a stay beyond a de minimis period,
voided or reversed. In jurisdictions where close-out netting may not be legally enforceable,
banks should ensure that they have compensating risk management controls in place.28
6.2
A bank conducting business in multiple jurisdictions should identify, measure, monitor
and control for the risks arising from conflicts of laws across jurisdictions. The identification of
legal risk in various jurisdictions can be accomplished through (i) legal opinions upon which a
bank is entitled to rely that are commissioned by, and addressed to, a trade organisation or an
FMI of which a bank is a member; or (ii) legal opinions provided by the banks in-house or
external counsel who are licensed to practice law in the jurisdictions for which they are
providing such opinions. All opinions should be reviewed for legal sufficiency by bank counsel,
and be updated, on a regular basis.
6.3
Changes in law (e.g., new or changing legal restrictions on the use of currency) may
adversely impact a banks FX activities by rendering agreements and contracts unenforceable. A
bank should have procedures to monitor for, and promptly assess, changes in law relevant to its
FX agreements and contracts in jurisdictions in which it is doing business and jurisdictions of the
currencies in which it transacts.
6.4
If a banks agreements and contracts are not legally enforceable, a bank may find itself
with significant unexpected and/or un-hedged foreign exchange obligations. The financial
ramifications for a bank that has actively traded in that currency could be severe.
26

27
28

Legal risk is addressed as a separate principle from operational risk in this guidance. However, under the Basel
capital framework, the definition of operational risk encompasses legal risk, which includes the legal uncertainty
or difference across jurisdictions associated with FX settlement.
In particular, contracts, and actions taken under contracts, include close-out netting and collateral agreements.
Compensating risk management controls may include, but not be limited to, reducing FX activities in the
relevant jurisdictions, imposing counterparty limits and settling transactions on a gross basis.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 17

Settlement finality
6.5
A bank should obtain legal advice that addresses settlement finality with respect to its
settlement payments and deliveries. The legal advice should identify material legal uncertainties
regarding settlement finality so that the bank may assess when key financial risks are transferred.
The legal advice and banks assessment should also take into consideration the impact of
relevant bankruptcy and insolvency laws and relevant resolution regimes. A bank needs to know
with a high degree of certainty when settlement finality occurs as a matter of law and plan for
actions that may be necessary if settlement finality is not achieved as a matter of law.
6.6
A bank should ensure that relevant contracts, including those with correspondent banks
(nostro agents), specify the point at which funds are received with finality, and the point at which
instructions become irrevocable and unconditional, taking into consideration the impact of
relevant bankruptcy and insolvency laws and relevant resolution regimes.
6.7
A bank should clearly communicate the legal status of on-us settlements so that their
customers and counterparties know when finality of settlement is achieved as a matter of law.
Principle 7: Capital for FX transactions
As part of its Internal Capital Adequacy Assessment Process and stress testing program, a bank
should assess the potential for material loss arising from its exposure to FX settlement (or
principal) risk. A banks internal capital target should reflect this exposure, as appropriate.
OSFIs Expectations
Key considerations
1. A banks analysis of its Internal Capital Adequacy Assessment Process (ICAAP) and
stress testing program should address all FX settlement-related risks, including those
related to operational risk.
FX settlement risk
7.1
As part of its ICAAP and stress testing program, a bank should assess the potential for
material loss arising from its exposure to FX settlement risk which is distinct from its exposure
to pre-settlement counterparty credit risk.29
7.2
More specifically, when considering its internal capital needs related to operational risk, a
bank should assess its exposure to material loss arising from counterparty non-performance in

29

Banks should refer to Chapter 4: Settlement and Counterparty Risk in OSFIs 2013 Capital Adequacy
Requirements Guideline for information on the regulatory capital treatment of pre-settlement counterparty credit
risk pertaining to transactions covered under the scope of the Basel Committees Supervisory guidance for
managing risks associated with the settlement of foreign exchange transactions.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 18

the settlement of FX trades outside of payment-versus-payment settlement arrangements.30 A

banks assessment should reflect the accurate identification and measurement of its exposure to
FX settlement risk, and should also consider the banks existing risk mitigation practices and
internal controls, and the risks inherent in payments systems used to settle FX trades.31 The
assessment should be conditioned by the banks own historical loss experience and, owing to the
remoteness of such losses, by external loss data where practicable. Moreover, the assessment
should incorporate stress-testing to the extent possible, as a means of estimating potential loss
arising from non-PvP FX settlement under a variety of exceptional, yet plausible, risk scenarios.
7.3
Given the level of potential loss identified in the assessment, a bank would be expected to
implement a plan of action to address this exposure as needed. To some extent, this exposure
has been captured under Pillar 1. However, banks still need to assess this risk through their
ICAAP and stress testing. If the residual risk (not covered in Pillar 1) is deemed material, OSFI
expects banks to capitalize it under their ICAAP framework. Moreover, a bank is expected to
review its FX settlement risk profile on a regular basis, including whether size of potential loss,
use of risk mitigation techniques and internal control practices combine to produce a result that is
consistent with its overall risk appetite, and whether further adjustments to its FX settlement risk
management strategy are necessary.

30

31

As the name indicates, payment-versus-payment (or PvP) settlement mechanisms are designed to virtually
eliminate principal risk arising from counterparty non-performance in the settlement of foreign exchange
transactions. The CLS system currently serves as the industry standard for PvP settlement of FX-related trades.
Banks should refer to Principle 2 for further information on the appropriate measurement of FX principal risk, as
well as on recommended application of risk mitigation techniques and internal controls in the context of this risk.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 19

Annex
FX settlement-related risks and how they arise

1.
In the period between FX trade execution and final settlement, a bank is exposed to a
number of different risks. The risks vary depending on the type of pre-settlement and settlement
arrangements. A bank needs to understand the risks associated with FX transactions in order to
adequately manage them.
2.
Section A describes principal risk, replacement cost risk and liquidity risk. Section B
identifies and describes the presence of operational and legal risks between trade execution and
final settlement. Finally, Section C discusses the various pre-settlement and settlement
arrangements and their impact on risks.
3.
For the purposes of exposition, the risks are described from the point of view of "a bank"
and a failed FX "counterparty" of that bank. Section A describes the risks relating to a single FX
trade between a bank and its counterparty. This is generalised to multiple trades in Sections B
and C.

A.

Risks relating to counterparty failure to deliver the expected currency

4.
The three main risks associated with FX transactions are principal risk, replacement cost
risk and liquidity risk, which arise due to the possibility that a counterparty may fail to settle an
FX trade. This failure may be temporary (e.g. operational or liquidity problems of the
counterparty) or permanent (e.g. counterparty's insolvency). A bank may become aware of a
potential failure at any time between trading and the completion of settlement, particularly if the
problem is due to insolvency. However, sometimes, a bank may only know that a problem has
occurred on or after settlement day when it does not receive the currency that the counterparty
was expected to deliver. Initially, a bank may not be able to identify the cause of the failure, nor
determine whether the failure is temporary or permanent.
5.
A bank is exposed to principal risk, replacement cost risk and liquidity risk until it
receives the bought currency with finality.
Principal risk
6.
Principal risk is the risk that a bank pays away the currency being sold, but fails to
receive the currency being bought. Principal risk can be the most serious risk because the amount
at risk can be equal to the full value of the trade.32
7.
Principal risk exists when a bank is no longer guaranteed that it can unilaterally cancel
the payment of the currency it sold (the unilateral cancellation deadline). Given that a bank's
32

The maximum loss is the principal value of the trade. The actual loss will depend on the outcome of the
counterparty's insolvency proceedings.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 20

unilateral payment cancellation deadline may be one or more business days before the settlement
date, this risk can last for a significant period of time.33
Replacement cost risk
8.
Replacement cost risk is the risk that an FX counterparty will default before a trade has
settled and that the bank must replace it with a new trade and a different counterparty at current
market prices (potentially less favourable exchange rate). As such, the bank may incur a loss
relative to the original trade. Replacement cost risk exists throughout the period between trade
execution and final settlement.
Liquidity risk
9.
Liquidity risk is the risk that a counterparty will not settle an obligation for full value
when due. Liquidity risk does not imply that a counterparty is insolvent since it may be able to
settle the required debit obligations at some unspecified later time.
10.
Liquidity risk exists in addition to replacement cost risk. Whether a default is just a
replacement cost problem or turns into a liquidity shortage depends on whether a bank can
replace the failed trade in time to meet its obligations or, at least, to borrow the necessary
currency until it can replace the trade. In principle, liquidity risk can exist throughout the period
between trade execution and final settlement. In practice, the probability of the problem
materialising as a liquidity shortage and a replacement cost depends on many factors, including:

The timing of the default. The closer the default is to the settlement date, the less time a
bank has to make other arrangements.

Whether a bank has already irrevocably paid away the currency it is selling. If so, the
bank may have fewer liquid assets available to pay for the replacement trade or to use as
collateral to borrow the currency it needs.34

The nature of the trade. The less liquid the currency being purchased and/or the larger the
value of the trade, the harder it may be to replace.

11.
A bank may find it hard to predict the probability of a liquidity shortage, as it cannot
make a sound judgment based solely on normal market conditions. However, there is a strong
positive correlation between a counterparty default and illiquid markets (i.e. the default may be
the cause of the market illiquidity or an effect of it). In addition, trades that are easy to replace in
normal conditions may be impossible to replace when markets are less liquid and experiencing
stressed conditions.

33

34

For more information on how principal risk arises when settling FX trades, see Progress in reducing foreign
exchange settlement risk, CPSS, May 2008.
In this case, FX settlement-related principal risk will also exist.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 21

B.

Operational and legal risks

12.
A bank may also face FX settlement-related risks caused by weaknesses in its own
operations and weaknesses in the legal enforceability of contractual terms and the governing law
applicable to its transactions. If a bank has inadequate operational capabilities or if there are
weaknesses in the legal basis for the pre-settlement and settlement arrangements, it can face
increased principal risk, replacement cost risk and liquidity risk relating to counterparty failure.
13.
Operational risk is the risk of loss due to external events or inadequate or failed internal
processes, people and systems. This definition includes legal risk and excludes strategic and
reputational risk.
14.
Inadequate skills and insufficient processing capacity may increase potential exposures.
These weaknesses can cause operational delays, inaccurate confirmation and reconciliation, or an
inability to quickly correct or cancel payment instructions.
15.
Legal risk occurs when a counterpartys contractual FX obligations are non-binding,
unenforceable and subject to loss because (i) the underlying transaction documentation is
inadequate; (ii) the counterparty lacks the requisite authority or is subject to legal transaction
restrictions; (iii) the underlying transaction or contractual terms are impermissible and/or conflict
with applicable law or regulatory policies; or (iv) applicable bankruptcy or insolvency laws limit
or alter contractual remedies.
16.
Legal problems may affect settlement of a foreign exchange transaction. Legal issues
may compromise the legal robustness of netting, the enforceability of unilateral cancellation
times or certainty about the finality of the receipt of currency.

C.

Impact of pre-settlement and settlement arrangements on risks

17.
FX settlement-related risks may be affected by the type of pre-settlement and settlement
arrangements used by a bank. Risk implications for the most common arrangements are
described below. This section focuses on the implications for the risks related to counterparty
failure described in Section A. Different pre-settlement and settlement arrangements can also
impact the operational and legal risks described in Section B some arrangements may be
operationally more complex, require more demanding risk management or create different legal
risks. However, since these implications can vary from bank to bank and depend on specific
circumstances, they are not covered in this section.
Close-out netting
18.
Legally robust and enforceable netting arrangements can be a safe and efficient method
for reducing settlement exposures. In the context of bilateral FX transactions, close-out netting is
a specific type of netting that establishes a close-out payment based on the net present value of
future cash flows between a bank and a defaulting counterparty. This involves two counterparties
entering into a formal bilateral agreement stipulating that, if there is a defined "event of default"
(e.g. insolvency of one of the counterparties), the unpaid obligations covered by the netting
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 22

agreement are netted. The value of those future obligations is calculated to a net present value,
usually in a single-base currency. Thus, a series of future dated cash flows is typically reduced to
one single payment due to, or from, the closed-out counterparty.
19.
Legally enforceable close-out netting reduces principal risk, replacement cost risk,
liquidity risk and operational risk for unsettled future obligations. Without close-out netting, a
bank may be required to make principal payments to a defaulted counterparty. This risk is
particularly relevant in jurisdictions without statutory provision or with weak or ineffective
provision for offset of obligations with a defaulted counterparty. Thus, a bank may face gross
principal risk, replacement cost risk and liquidity risk on transactions not covered by a legally
enforceable netting agreement.
Bilateral obligation netting
20.
Under bilateral obligation netting, FX transactions between two counterparties due to
settle on a certain date are netted to produce a single obligation to pay in each currency on that
date (i.e. each counterparty has an obligation to pay a single amount in those currencies in which
it is a bilateral net seller). Those net amounts are likely to be smaller than the original gross
amounts, reducing principal and liquidity risks. Obligation netting can take different forms (e.g.
netting by novation) and may vary by jurisdiction. Their effectiveness depends on the legal
soundness of the contractual terms.
Collateral arrangements
21.
If netting is accompanied by a collateral arrangement, replacement cost risk can be
reduced further. A collateral arrangement is where the counterparty with the negative net
position provides financial assets to the other counterparty in order to secure that obligation.
Collateral could be taken to cover only price movements that have already occurred. However, in
this case, if there is a counterparty default, a bank is still exposed to further movements that may
occur between the time collateral was last taken and the time that the bank succeeds in replacing
the trade (potential future exposure). Further protection can be achieved if collateral is also taken
to cover the potential future exposure. Since the actual size of this exposure cannot be
determined until after the event, the degree of additional protection depends on the assumptions
made when calculating the collateral amount.35 Note that such collateral arrangements are
typically not used to provide protection against liquidity or principal risk.
Settlement via traditional correspondent banking
22.
Under this settlement method, each counterparty to an FX trade transfers to the other
counterparty the currency it is selling, typically using their correspondent banks for the
currencies concerned. Once a payment instruction is irrevocable, the full amount being
transferred is subject to principal risk, and some portion may be subject to replacement cost risk
and liquidity risk.

35

As with any collateral arrangement, there is a risk that the value of the collateral may decline. Thus, the degree
of protection against both current and potential future exposure also depends on the type of collateral and the
haircut applied.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 23

On-us settlement
23.
On-us settlement is where both legs of an FX transaction are settled across the books of a
single institution. On-us settlement can occur either where one counterparty to a transaction
provides accounts in both currencies to the other counterparty, or where one institution provides
accounts to both counterparties to an FX transaction in both currencies.36 The account provider
debits one of its customers accounts and credits the other, while making opposite debits and
credits to its own account. Those credits can be made simultaneously (via PVP) or at different
times, in which case one counterparty may be exposed to principal risk from the other
counterparty. Irrespective of whether principal risk exists, normal correspondent credit risks are
also likely to exist.
Payment-versus-payment settlement
24.
Payment-versus-payment (PVP) settlement is a mechanism that ensures the final transfer
of a payment in one currency if, and only if, a final transfer of a payment in another currency
occurs, thereby removing principal risk. There are various forms of PVP settlement
arrangements, including the type offered by CLS Bank International (CLS Bank). 37 Another
form consists of a link between payment systems in the two currencies, where a payment is made
in one system if, and only if, payment is made in the other system. PVP arrangements do not
guarantee settlement. In a basic PVP arrangement, a trade will settle only if a bank and its
counterparty pay in the correct amount. If the counterparty fails to pay in, a bank will receive
back the currency it was selling, thus providing protection against principal risk. However, it will
still be short on the currency that it was buying and face liquidity risk equal to the full amount of
that currency, as well as the replacement cost risk on that amount.
Central clearing
25.
A central counterparty (CCP) is an entity that interposes itself between counterparties to
trades in a financial market, thus, becoming the buyer to every seller and the seller to every
buyer. In this way, a form of multilateral obligation netting is achieved among the original
counterparties. Currently, CCPs for FX trades involving an exchange of payments at settlement
are rare, but they may become more widespread in the future.
Indirect participation in settlement or CCP arrangements
26.
A bank may choose to be an indirect participant of a settlement or CCP arrangement (i.e.
a customer of a direct participant). In this case, the FX settlement-related risks a bank faces will
depend, in part, on the exact terms of the service provided by the direct participant. Thus, the
risks associated with indirect participation may not be the same as those associated with direct
participation.

36
37

For example, a bank provides accounts to two of its customers, which have traded with each other.
For a description of the CLS system, see Progress in reducing foreign exchange settlement risk, CPSS, May
2008, Annex 4.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 24

Glossary
Bilateral netting

A general term describing an arrangement to offset the obligations

between two parties to a single bilateral obligation. The obligations
covered by the arrangement may arise from financial contracts,
transfers or both.

Bilateral obligation
netting

A form of netting where two counterparties agree (via a legallyenforceable netting agreement) to settle transactions by making or
receiving a single payment in each of the currencies (i.e. each
counterparty has an obligation to pay a single amount in those
currencies in which it is a bilateral net seller). This reduces the value
at risk by replacing multiple gross obligations (that would, otherwise,
be settled on a trade-by-trade basis) with one netted obligation.

Central counterparty
(CCP)

An entity that interposes itself between counterparties to trades in a

financial market, becoming the buyer to every seller and the seller to
every buyer.

Close-out netting

A form of netting which occurs following some predefined events,

such as default. Close-out netting establishes a close-out payment
based on the net present value of future cash flows due between a
bank and a defaulting counterparty. Close-out netting is intended to
reduce exposures on open contracts with a defaulting counterparty.
(Also referred to as default netting, open contract netting or
replacement contract netting).

CLS Bank
International (CLS
Bank)

Owned by the foreign exchange community, CLS Bank operates a

multi-currency PVP cash settlement system to mitigate settlement risk
in the foreign exchange market.

Confirmation and
affirmation

The process in which the terms of a trade are verified either by market
participants or by a central entity. A trade confirmation is legal
evidence of the terms of an FX transaction. Trade affirmation involves
acknowledging a counterparty trade notification or confirmation. Both
trade confirmation and affirmation can take many forms (e.g.
electronic, paper or voice over a recorded phone line).

Contingency
planning

The development of practical and credible plans to promote resiliency

during periods of severe financial distress and to facilitate a rapid
resolution. The plans should ensure access to relevant information in a
crisis and help evaluate resolution options.

Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 25

Correspondent
banking

An arrangement in which one bank (correspondent) holds deposits

owned by other banks (respondents) and provides payment and other
services to those respondent banks. Such arrangements may also be
known as agency relationships in some domestic contexts. In
international banking, balances held for a foreign respondent bank
may be used to settle FX transactions. Reciprocal correspondent
banking relationships may involve the use of nostro and vostro
accounts to settle foreign exchange transactions.

Credit support annex

(ISDA CSA)

A legal document that regulates credit support (collateral) for

derivative transactions. It is one of the four parts that make up an
ISDA master agreement, but is not mandatory. A CSA defines the
terms or rules under which collateral is posted or transferred between
swap counterparties to mitigate the credit risk arising from "in the
money" derivative positions. Terms include thresholds, minimum
transfer amounts, eligible securities and currencies, haircuts applicable
to eligible securities and rules for settling or resolving disputes over
valuation of derivative positions.

Currency swap

An agreement between two parties to exchange aspects (namely the

principal and/or interest payments) of a loan in one currency for
equivalent aspects of a loan in another currency at some point in the
future according to a specified formula. Currency swaps are over-thecounter derivatives and are closely related to interest rate swaps.
However, unlike interest rate swaps, currency swaps generally involve
the exchange of the principal. (Also known as a cross-currency
swap).

Derivatives

Financial contracts whose values depend on the value of one or more

underlying reference assets, rates, currencies or indices.

Enforceable

A legal document, agreement, right or obligation is enforceable if the

party obligated can be forced or ordered to comply through a legal
process.

Fail

A failure to settle a transaction on the contractual settlement date,

usually due to technical or temporary difficulties. Fails typically arise
from operational problems, while defaults arise from credit or
solvency problems. (Also known as a failed transaction).

Financial market
infrastructure (FMI)

A multilateral system among participating institutions, including the

operator of the system, used for purposes of clearing, settling or
recording payments, securities, derivatives or other financial
transactions.

FX forward

A contract between two parties that agree to buy or sell an amount of

currency against a second currency at a specified future date (more
than two business days later) and at an agreed-upon rate on the date of
the contract.

Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 26

FX spot

The purchase of one currency for another, with immediate delivery

according to local market convention (usually two business days) at an
agreed-upon price on trade date.

FX swap

A contract between two parties that simultaneously agree to buy or

sell an amount of currency against a second currency at an agreedupon rate; and to resell or repurchase the same currency at a later date
with the same counterparty, also at an agreed-upon rate.

Governance

The set of relationships among a banks Board, management,

shareholders and other interested parties or stakeholders. Governance
also provides the structure for setting company objectives, the means
of attaining those objectives and the framework for monitoring
performance.

In/out swap (with

regard to CLS Bank
only)

An in/out swap comprises two equal and opposite FX transactions that

are agreed-upon as an intraday swap between two CLS Bank
settlement members. One of the two FX transactions is settled through
CLS Bank to reduce each member's net position in the two currencies.
The other transaction is settled outside of CLS Bank. The combined
effect of these two FX transactions reduces funding requirements of
the two members during the CLS Bank settlement session, but leaves
the institutions' overall FX positions unchanged.

Initial margin

Collateral that is collected to cover potential changes in the value of

each participants position (also known as potential future exposure)
over the appropriate close-out period in the event the participant
defaults.

Legal risk

The risk of an unexpected application of a law or regulation, usually

resulting in a loss.

Liquidity risk

The risk that a bank is unable to make payments due to a shortage of

liquidity arising from a counterparty (or participant in a settlement
system) not settling an obligation for full value when due. Liquidity
risk does not imply that a counterparty or participant is insolvent since
it may be able to settle the required debit obligations at some
unspecified later time.

Margin call

A demand for additional funds or collateral (following the marked-tomarket of a margined transaction) if the market value of the
underlying collateral falls below margin requirements.

Master netting
agreement

A master netting agreement (e.g. ISDA or IFEMA) sets forth the

standard terms and conditions applicable to all, or a defined subset of,
transactions that the parties may enter into from time to time. Includes
the terms and conditions for close-out and obligation netting.

Multilateral netting

Netting on a multilateral basis is the offsetting of obligations between

or among multiple participants to a net position per participant.

Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 27

Non-deliverable
forwards (NDFs)

An outright forward or futures contract in which counterparties settle

the difference between the contracted NDF price or rate and the
prevailing spot price or rate on an agreed notional amount.

Nostro account

A foreign currency-denominated account (usually at a foreign bank)

where a domestic bank keeps reserves to maintain its balance in that
currency and to make and receive payments.

On-us settlement

On-us settlement is where both legs of an FX transaction are settled

across the books of a single institution. On-us settlement can occur
either where one counterparty to a transaction provides accounts in
both currencies to the other counterparty, or where one institution
provides accounts to both counterparties to an FX transaction in both
currencies.38 The account provider debits one of its customers
accounts and credits the other, while making opposite debits and
credits to its own account.

Operational risk

The risk of loss resulting from inadequate or failed internal processes,

people and systems, or from external events. This definition includes
legal risk and excludes strategic and reputational risk.

Payment-versuspayment (PVP)
settlement

A settlement mechanism that ensures the final transfer of a payment in

one currency if, and only if, a final transfer of a payment in another
currency occurs.

Potential future
exposure

The most common measure of forward-looking exposure. It is the

maximum expected exposure over a specified interval of time
calculated at some level of confidence. Potential future exposure is the
additional exposure that a counterparty might potentially assume
during the life of a contract, or set of contracts, beyond the current
replacement cost. It is calculated by evaluating existing trades
executed against possible market prices in the future. Both initial
margin and variation margin mitigate this future exposure. Variation
margin mitigates actual price volatility so that the price protection
provided by initial margin is maintained.

Prime brokerage

A service that enables a banks customer to conduct transactions in the

name of the bank (the prime broker). The prime broker sets up an
arrangement that permits the customer to trade directly with dealers in
the name of the prime broker. These dealers recognise the prime
broker (not the customer) as the counterparty in these trades.

Principal risk

The risk of outright loss of the full value of a transaction resulting

from the counterpartys failure to settle. This can arise from paying
away the currency being sold, but failing to receive the currency being
bought. (Also referred to as Herstatt risk).

38

For example, a bank provides accounts to two of its customers, which have traded with each other.
Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 28

Principal risk
duration

The length of time that a bank might be exposed to principal risk from
an FX transaction. This length of time extends from the unilateral
payment cancellation deadline to the time a bank receives, with
finality, the purchased currency. (There may also be additional time
needed for a bank to confirm receipt of the expected settlement
payment and to reconcile the settlement payment against its
outstanding transactions.) Depending on the internal practices,
procedures or any legal agreements of a bank and its correspondent
bank, the duration of a bank's principal risk may begin as soon as the
bank submits its payment order for a sold currency.

Real-time gross
settlement (RTGS)

The continuous (real-time) settlement of funds or securities on an

order-by-order basis (without netting).

Replacement cost risk The risk of loss due to unsettled transactions with a counterparty. The
resulting exposure is the cost of replacing the original transaction at
current market prices.
Risk appetite

A high-level determination of how much risk a bank is willing to

accept considering risk/return attributes. Risk appetite is a forwardlooking view of risk acceptance.

Settlement finality

The irrevocable and unconditional transfer of an asset or financial

instrument, or the discharge of an obligation by the FMI or its
participants in accordance with the terms of the underlying contract.
Final settlement is a legally defined moment.

Straight-through
processing (STP)

Automated processing that allows data to be entered into technical

systems once and is then used for all subsequent processing of
transactions.

Stress test

An estimation of credit and liquidity exposures that would result from

extreme price and implied volatility scenarios.

Unilateral payment
cancellation deadline

The point in time after which a bank is no longer guaranteed that it

can recall, rescind or cancel (with certainty) a previously submitted
payment instruction. This deadline varies depending on the currency
pair being settled, correspondent payment system practices, and
operational, service and legal arrangements.

Variation margin

Variation margin is an amount of collateral posted to cover exposures

resulting from actual changes in market prices. (Also known as
mark-to-market margin).

Banks/BHC/T&L
June 2013

Foreign Exchange Settlement Risk

Page 29